Opinion: Reasons for the Aug5 Sharp Drop: BOJ Rate Hike and Exit of Yen Arbitrage

Aug 05, 2024

Author: @Web3Mario (https://x.com/web3_mario)

Summary: This week, I have been learning about some Telegram Bot APIs, and I have almost completed the framework for the TON contract. I was initially quite happy, but the sharp decline in the crypto market on Monday cast a shadow over my mood. Although I had anticipated this outcome to some extent, I didn’t expect it to come so quickly and so fiercely. Therefore, I have compiled some of my thoughts to share with everyone, hoping you can maintain your composure and not let panic influence your investment decisions. Overall, the core reason for the sharp pullback in risk assets led by U.S. tech stocks is the aggressive interest rate hike by the Bank of Japan, which caused many yen carry trade paths to fail or face significant risks, specifically in three areas: exchange rate fluctuations, interest rate reversals, and liquidity risks. Facing these risks, “Mrs. Watanabes” are unwinding their positions to repay yen debt and reduce risks.

Abenomics and Japan’s Long-term Negative Interest Rate Environment Have Made the Yen an Important Global Financing and Carry Trade Asset

Those with a bit of an economics background are likely familiar with the so-called “Lost 20 Years of Japan.” After the Japanese bubble economy burst in the early 1990s, the economy fell into long-term stagnation, entering the so-called “Lost Decades.” During this period, economic growth was slow, and both corporate and individual investment willingness was low, leading to persistent deflation. To counter the economic slump, the Bank of Japan began implementing a low-interest-rate policy in the late 1990s, lowering the benchmark interest rate to near-zero levels to stimulate economic activity by reducing borrowing costs. As traditional monetary policy tools became less effective,

It was in this context that former Japanese Prime Minister Shinzo Abe launched a series of economic policies after taking office for the second time in 2012. The core goal of these policies was to stimulate economic growth, end long-term deflation, and address structural issues in the Japanese economy. The core framework of Abenomics consists of “three arrows,” of which I will briefly introduce its bold monetary policy, mainly comprising two aspects: First, the Bank of Japan implemented large-scale quantitative easing. This meant that the Bank of Japan injected large amounts of funds into the market by purchasing government bonds and other assets to lower interest rates and increase liquidity. Second, the Bank of Japan officially introduced a negative interest rate policy in 2016. The intention of this policy was to further reduce interbank borrowing costs, encouraging more funds to flow into the real economy, thereby boosting consumption and investment and raising inflation expectations. It’s worth noting that “negative interest rates” here do not mean that the lender needs to pay interest to the borrower, but rather that the real interest rate is negative, meaning the interest rate is lower than the domestic inflation rate.

Against this backdrop, a type of arbitrage trading gradually became popular, namely yen carry trade. The market gave traders who engage in this arbitrage trade an interesting name, “Mrs. Watanabe.” Yen carry trade refers to an investment strategy based on interest rate differences. Its basic principle is to borrow low-interest-rate currency (such as the yen) and then invest the funds in high-interest-rate currencies or high-yield assets to earn the interest rate differential. The operation principle is as follows:

1. Borrowing Yen: Since Japanese interest rates are very low (sometimes close to zero), investors can borrow yen at a very low cost.

2. Exchanging for High-Yield Currency: The borrowed yen is exchanged for another currency with a higher interest rate, such as the Australian dollar or New Zealand dollar.

3. Investing in High-Yield Assets: The funds are then invested in bonds, deposits, or other assets in the high-yield currency country to earn higher interest income.

4. Interest Rate Differential Income: The investor’s profit comes from the difference between the borrowing cost (low-interest-rate yen loan) and the investment income (high-interest-rate assets).

This type of interest rate arbitrage trading is also widely spread in the DeFi field, typically seen in LSD-ETH interest rate arbitrage. For instance, using stETH as collateral on lending platforms like Compound to borrow ETH and then exchanging it back to stETH. If the borrowing rate of ETH is lower than the yield rate of stETH during the entire process, there is room for interest rate arbitrage. The same principle applies in the yen carry trade market. Generally, there are two operation paths: the first one uses U.S. assets as collateral to borrow yen and directly purchase high-dividend stocks of Japan’s five major trading companies. This is one of Warren Buffett’s core investment portfolios in recent years. The second path involves borrowing yen and then selling it for dollars to buy high-interest-rate financial instruments such as U.S. stocks and bonds. This is similar to the DeFi cycle lending strategy mentioned earlier.

This type of trading became extremely popular as the U.S. officially entered a rate hike cycle in 2022. With the Federal Reserve raising interest rates, major global economies also entered rate hike cycles to stabilize exchange rates and prevent capital outflows. Only Japan insisted on its low-interest-rate policy, making the yen the main low-cost financing source in the tightening cycle. Of course, some might say the renminbi interest rate is also very low, but considering the international political context and China’s financial sovereignty dividends, the renminbi is not suitable as a carry trade asset. Therefore, it can be said that during this tightening cycle, the reason why the U.S. “Tech Seven Sisters” market remained buoyant was due to the support of the yen.

This has both good and bad effects on Japan. On the positive side, due to the “Buffett arbitrage path,” Japanese stocks experienced long-term growth, creating a rare “wealth effect” domestically. We know that the vitality of an economy mainly builds on the wealth effect. Only when people find it relatively easy to gain wealth and remain optimistic about future returns will they dare to leverage investments or consumption, thereby creating economic vitality. With the help of foreign capital, Japan experienced a surge in “Nippon Value,” bringing about a wealth effect that shifted Japan from long-term deflation to moderate inflation, essentially achieving Abenomics’ original goal.

However, on the other hand, another arbitrage path resulted in a large amount of yen being exchanged for dollars to purchase U.S. assets, leading to a long-term depreciation trend of the yen against the dollar. From 2021 to 2024, the dollar to yen exchange rate rose from a low of 103 to 160, a depreciation of over 60% for the yen. But considering the impact of exchange rate fluctuations on national perception, it hasn’t strongly affected domestic sentiment, so even with such depreciation, inflation in Japan has been steadily rising.

The Bank of Japan’s Forward Guidance and Speculative Market Confrontation Recently Came to an End, Yen Sees a V-shaped Reversal

After more than two years, the trend recently reversed, naturally due to the U.S. rate hike cycle nearing its end. In early 2024, the newly appointed Bank of Japan Governor Kazuo Ueda reversed the negative interest rate policy of his predecessor Haruhiko Kuroda and started providing forward guidance on rate hikes to the market. However, the market seemed skeptical and chose to confront the Bank of Japan. This led to the yen depreciating past 160 in the first half of this year. One interpretation is that the speculative market did not believe in the sustainability of Japan’s inflation and thought Japan would return to deflation once the U.S. entered a rate-cut cycle. Another interpretation comes from the complex hedging needs within the yen carry trade paths, where the core is Nvidia. Simply put, Japanese electronics and chip stocks, Taiwanese semiconductors, and Nvidia have strong correlations in stock prices due to political and industrial transfer contexts. For a long time, buying Japanese chip stocks was an important channel to capture alpha returns in the AI sector. However, entering 2024, U.S. stocks have shown a clear “contraction” trend, with capital flocking to the top, specifically Nvidia, leading to a decoupling of Japanese chip stocks from Nvidia. To avoid losing future alpha returns by selling Japanese electronics stocks, many funds have a hedging need, thus selling yen to buy Nvidia became a good choice. This viewpoint comes from an economist I highly admire, Peng Fu. If interested, you can read about this logic in his public account.

Regardless of the reasons, this confrontation ended last Wednesday when the Bank of Japan officially raised interest rates by 15 basis points, far exceeding market expectations. This marked the market’s official reversal. First, we can see that the dollar to yen exchange rate quickly rose from 160 to 143 at the time of writing. Consequently, the yen carry trade officially ended, and many traders began unwinding their positions, leading to a massive sell-off of dollar-denominated risk assets, converting them back to yen to repay debts.

Therefore, after the weekend, with the market fully digesting the news of Japan’s rate hike, the unwinding of positions reached its climax, leading to the crypto market crash on August 5. One piece of evidence supporting this is that the decline in income-producing assets far exceeded that of zero-interest assets like Bitcoin, particularly ETH, which are core targets for interest rate arbitrage.

In the U.S.-Japan Alliance, the Bank of Japan Plays a Supporting Role, and the Dollar Ultimately Determines Future Trends

Here, I hope to provide a brief outlook on future trends. I hope everyone won’t be frightened by this pullback. Despite the significant scale of the yen carry trade, I believe that in the U.S.-Japan alliance, Japan actually plays a supporting role. The recent rate hike announcement by Japan is merely to match U.S. monetary policy. We know that the reason the U.S. has not entered a recession early and why the Federal Reserve has delayed cutting interest rates is due to the active U.S. stock market. Even though small and medium-sized enterprises are struggling, the wealth effect brought by the “Tech Seven Sisters,” particularly Nvidia, has kept the U.S. GDP buoyant through the financial sector. If the U.S. were to cut interest rates prematurely, it would significantly stimulate the risk market, potentially reigniting inflation, which is obviously unacceptable. However, considering the current economic situation in the U.S., it has no choice but to cut interest rates. Therefore, the Federal Reserve needs to find a reason to justify a rate cut, and that reason is actually the pullback in the U.S. stock market. Thus, the Bank of Japan’s action can be understood as part of this policy coordination.

So, when the U.S. officially enters a rate-cutting cycle, with liquidity easing again, crypto assets will inevitably recover. Therefore, everyone should remain patient and optimistic about the future. Of course, for those with high leverage, appropriately reducing leverage is an unavoidable choice.

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